When conducting a private offering, there are several facts and circumstances to weigh when deciding on a safe harbor. Section 4(a)(2) of the U.S. Securities Act of 1933, as amended, and the rules and regulations promulgated thereunder provides an exemption from registration for companies (issuers) that offer securities in a private offering. Rule 506(b) and Rule 506(c) of Regulation D are safe harbors that issuers can rely on to ensure they are in compliance with Section 4(a)(2) of the Securities Act.
Rule 506(b) permits an issuer to issue securities in a private offering as long as the issuer does not engage in general solicitation or advertising; only issues securities to 35 or fewer non-accredited investors; and files a Form D with the U.S. Securities and Exchange Commission (the SEC).
Rule 506(c) permits an issuer to engage in general solicitation and advertising to issue securities in a private offering, as long as the issuer takes reasonable steps to verify that all investors are accredited investors and files a Form D with the SEC. Examples of reasonable verification for a natural person include any of the following:
No.1: Reviewing the potential investor’s IRS forms for the previous two years and obtaining a written confirmation that such potential investor reasonably expects to meet the accredited investor income threshold in the current year.
No. 2: Reviewing third-party statements (including, but not limited to, bank statements, brokerage statements, consumer reports, etc.) dated within the previous three months that show the potential investor’s assets and liabilities and obtaining a written confirmation that the disclosed liabilities fully reflect such investor’s financial obligations
No. 3: Obtaining a written confirmation from a registered broker-dealer, registered investment adviser, licensed attorney or certified public accountant that such person or entity has taken reasonable steps within the previous three months to verify that the potential investor is accredited.
Choosing Between Rule 506(b) and Rule 506(c)
The decision of whether to comply with Rule 506(b) instead of Rule 506(c), or vice versa, depends on the issuer. If the issuer has pre-existing relationships with potential investors, then the issuer may opt to comply with Rule 506(b) because the issuer may not feel the need to advertise to the public. Additionally, high net worth individuals and institutional investors often prefer to invest with issuers with whom they have a pre-existing relationship. On the other hand, issuers who may need to publicly raise funds would choose to conduct a private offering in compliance with Rule 506(c).
Irrespective of whether the issuer is relying on Rule 506(b) or Rule 506(c), issuers need to comply with the antifraud provisions under federal securities laws. Among other things, this means that they need to make sure that any information provided to an investor does not contain any misstatement or omission of a material fact. Therefore, issuers typically include disclaimers and other types of clarifying information in their offering materials, so a prospective investor can fully understand the potential risks of making an investment.
For example, an issuer that is an investment fund providing information related to prior performance should provide investors performance returns showing both gross returns and returns net of fees and incentive compensation. Additionally, when providing prior performance metrics, issuers should inform investors that prior performance is not indicative of future results. Furthermore, issuers generally notify investors of various factors that may materially and/or negatively impact actual results.
What Happens When an Issuer Violates One of These Rules?
If an issuer does not strictly adhere to Rule 506(b), it may still rely on the private offering exemption under Section 4(a)(2) of the Securities Act as long as the offering is made in accordance with the statute (this will depend on the facts and circumstances of the offering). On the other hand, if an issuer were to rely on Rule 506(c) without strict adherence to the safe harbor requirements, the issuer could not rely on Section 4(a)(2) if it had used general solicitation to market the offering. In that case, investors would be entitled to rescission rights (i.e., investors could withdraw their money).